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One thing is certain: uncertainty remains

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banace_4 February 2012 (Chinavestor) Many of you may recall our carefully optimistic view of the current year. We argued that bull markets climb a wall of worry and as such investors should be on a lookout. As it turned out, January was one for the record books. The Dow Jones Industrial Average (INDEXDJX:.DJI) advanced 3.4% for the month, marking its best January rally in the last 15 years. And if investors liked such an unusual January, how about a 4.2% advance for the Shanghai Composite Index (SHA:000001) or a staggering 10.6% surge for the Hang Seng Index (INDEXHANGSENG:.HSI)? Chinavestor compiled China ADR Index, measuring the performance of Chinese stocks listed in US exchanges, advanced 5.8% for the month.

Chinese technology stocks soared, led by Sina Corp. (NASDAQ:SINA) and solar names like Suntech Power (NYSE:STP). But Baidu.com Inc. (NASDAQ:BIDU) and Sohu.com Inc. (NASDAQ:SOHU) cheered investors as well. Energy stocks were good along with Mindray Medical (NYSE:MR) from the pharmaceutical sector.

It pays out looking at these numbers from a distance tough. Most of the gains for Chinese stocks was just enough to make a dent on a year long decline, just as the nearby chart testifies. Both the Shanghai Composite Index (SHA:000001) and the Hang Seng Index (INDEXHANGSWENG:.HSI) lost over 20% last year, making a case for a sizable correction. But even then, both key Chinese indices remain deep in the red for the last 13 months. The China ADR Index is halfway in between the Dow and key Chinese indices, a perfectly understandable position.

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The big question remains: where do we go from here? To find answers, first we have to find reasons for such a rally in January. Some argue that subsiding worries of an imminent European financial meltdown was primarily responsible for the rally. Others point to strong corporate earnings from the U.S. Some others find solace in an increase in December leading economic indicators.

Whatever it is, investors have to exercise caution going ahead. We find no reason to change our previous assumption of cautious optimism, articulated in our January Newsletter titled “Uncertainly creates opportunity for 2012”. But emphasis is on cautious. We are aware of certain indicators that changed from bad to worse and are a cause for concern.

For one, Europe isn’t out of the woods yet. There are a lot of unresolved issues involving Greece, Portugal and other peripheral counties that are most likely to leave the Euro zone before the end of the year. Besides the orderly disintegration of the euro zone, the credit crisis is evident by the following chart on this page. This Bloomberg screenshot clearly shows how non-financial credit and money supply (M3) continue to shrink along with household credit. This picture gives us a bleak picture of investment and consumption, two key components of economic activity. Investors in the US are going to feel a pinch if Europe gets stuck in a recession.

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And the damage will not be limited to the US alone. Europe is China’s largest trading partner and a cool-off in the EU will continue to hurt export sectors in the Middle Kingdom. And just how much European news move Chinese stocks, take a look at the Chinese solar sector. This particular sector is widely exposed to Europe, its largest export market by far. All four largest solar makers lost well over 50% of their market cap in the last 13 months.

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Besides Europe, recovery in the U.S. is gradual and some key indicators point to a bumpy recovery. Dismal new-home sales and a slump in housing prices continue to highlight the fundamental challenge the real estate sector is facing. And while there has been steady improvement on the jobs market, there is till a lot of work left to be done. Investors are taking note of all this. The S&P 500 is trading at 13.7 times earnings, a very modest number. Investors don’t seem to trust earnings even after a three year long bull market.

China has its own problems. For one, its largest export market is in trouble, just as we noted above. Second, the housing bubble is busting and while the effects may be contained, there is no one to know the exact spill over effect of falling property prices. Another factor investors have to consider is the unusually strong IPO pipeline for 2012 in Shanghai, creating liquidity problems for the A share market and related financial vehicles. We continue to like the Morgan Stanley China A-share Fund (NYES:CAF) albeit we don’t see much upside for February.

But investors should not loose their appetite due to some gloomy reports. China’s GDP is expected to grow at a healthy 8%-8.5% rate in 2012. Domestic consumption is going to play a central role by making up for a loss of exports to Europe. Investors should take a look at the passenger car and retail sales chart on his page. Remember, China has restricted car ownership in overcrowded cities like Beijing where a lottery system is in place to win number plates. That chart clearly illustrates how much China’s domestic consumption has increased despite all artificial curbs, making the Chinese economy less vulnerable to global ills.

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Another way to illustrate how much Chinese domestic consumption grew is by looking at Tim Cook’s assessment about Apple Inc.’s (NASDAQ:AAPL) inroad into China. The company pulled its 4Gs phone off the shelves earlier in January due to an insatiable appetite for its products. Tim Cook said that demand for Apple's iPhone “ is off the chart” in China and that the company can’t make enough of its iconic product to meet demand.

Another good news is that according to the latest figures, China is successfully reigning in on inflation. With inflation coming down, the Central Bank of China can ease monetary policy by cutting interest rates. This step is widely expected sometime in the second part of the year. Remember that China cut bank reserve ratios, money banks have to set aside, in late 2011 for the first time after 3 years of increases. China clearly has tools at its disposal to inject liquidity into its financial system and increase money supply and spur growth. That said, the 8%-8.5% economic growth looks viable for the world’s second largest economy.

Another key factor investors have to keep an eye on is corporate earnings. The earnings season for Chinese technology companies is going to shift into high gear in February. We continue to like stocks that can demonstrate sustainable revenue and earnings growth. Stocks that have demonstrated such capability in the past include Baidu.com Inc. (NASDAQ:BIDU), NetEase.com Inc. (NASDAAQ:NTES), Sohu.com Inc. (NASDAQ:SOHU), Ctrip.com (NASDAQ:CTRP) and 51job Inc. (NASDAQ:JOBS), among others. Sina Corp. (NASDAQ:SINA) is also a first class company although development costs for its Weibo.com named Twitter like service continues to dent into net income.

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We don’t have high hopes for social networking and related stocks for investment purposes at this time. While we are fully aware of the latest significant uptick in stock pries of Renren Inc. (NYSE:RENN), Tudou Hold. (NNASDAQ:TUDO), Youku.com (NYSE:YOKU) and Jiayuan.com (NASDAQ:DATE), most of the excitement is a spill over effect from Facebook’s proposed IPO and is not driven by fundamentals.

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Solar stocks make up an another important part of the technology sector but investors have to have a strong stomach to deal with such a volatile industry.

Besides some technology stocks, we continue to like energy and utility stocks. Mindray Medical (NYSE:MR), the largest among healthcare stocks, is of interest and may surprise investors to the upside.

Financial and basic material stocks plummeted in January, making them attractive in valuation. Another reason we like these sectors is that these stocks are cyclical oriented and interest rate sensitive, thus offering significant upside should monetary easing in China take place.

We continue to shun capital goods and consumer stocks in the upcoming earnings season.

Wish you successful investing,

Blaze Fabry.



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